Boston Fed's Rosengren Calls for Overhaul of Broker-Dealer Regulation

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Banks that own broker-dealers need to hold more capital to withstand runs and other shocks, the head of the Federal Reserve Bank of Boston said Wednesday.

Eric Rosengren, president of the regional Fed bank, joined the calls of other central bank officials who have argued that the risks of short-term wholesale funding need to be addressed. Broker-dealers' reliance on unstable, short-term funding – particularly repurchase agreements – leaves them exposed to runs and credit-market freeze-ups, he said.

Rosengren made the suggestion for more capital during a speech on the need to comprehensively reform the regulation of broker-dealers.

Reforms "should include a major re-examination of how broker-dealers are regulated, and an increase in the capital required for any holding company with significant broker-dealer operations," Rosengren said.

Other reforms Rosengren suggested include requiring broker-dealers to use more long-term funding or limiting what qualifies as acceptable collateral in repo agreements.

He also floated the idea of allowing broker-dealers access to the Fed's discount window during a crisis – a "complex and likely controversial" suggestion that he acknowledged is unlikely to go anywhere.

Yet the simplest reform would be requiring broker-dealers to hold "significantly more capital than they would if they used stable funding sources," he said. This would apply to broker-dealers within bank holding companies as well as independent broker-dealers and foreign entities with intermediate holding companies.

"To be sure, policy remedies would have an impact on the profitability of broker-dealers," he said. "But given recent history, that trade-off may be unavoidable and in the public interest from a financial stability perspective."

The speech is just the latest sign that the Fed is turning its attention to the risks posed by companies that rely heavily on wholesale funding. Rosengren noted that Fed Chairman Janet Yellen and Gov. Daniel Tarullo have also suggested that institutions that rely on wholesale funding should have higher capital levels, including perhaps tying capital levels to a bank's reliance on wholesale funding.

Rosengren's speech may also signal a more active role for the Fed in pushing reforms to the broker-dealer industry, which is primarily overseen by the Securities and Exchange Commission. Bank holding companies regulated by the Fed, including Bank of America, JPMorgan and Citigroup, own some of the country's largest broker-dealers, but the SEC is the primary regulator for the industry.

Even though broker-dealers played a significant role in the financial crisis, "the SEC's capital and liquidity requirements for broker-dealer entities have not materially changed since the crisis – leaving broker-dealers that are not in bank holding companies under a similar regulatory environment as before the crisis," said Rosengren.

Rosengren delivered his remarks in New York at a conference on the risks of wholesale funding, sponsored by the New York and Boston Feds. Fed officials have said they will make it a priority to address the risks of short-term funding but have yet to give a specific timeline for when they will act.

Rosengren emphasized just how heavy the reliance on wholesale funding has become over the past several decades. Financial institutions now receive only 20% of their funding from traditional depositary sources, meaning checking, savings and time deposits. That ratio was more than 40% in the early 1970s, Rosengren said.

He also argued that the financial crisis showed the danger of over-reliance on repurchase agreements, in which securities held by the borrower serve as a collateral for a loan. The repo market can provide cheap funding when confidence is high, but can lock up when lenders become reluctant to take back the collateral for the loan – as happened in 2008, Rosengren said. This was particularly a problem for money-market funds, which are often forbidden from holding the high-risk securities that often serve as collateral.

"During the financial crisis, we saw that many of those who traditionally lent to broker-dealers feared default by a broker-dealer – and did not want to risk having to take possession of the collateral associated with the repurchase agreement in the event of a default," he said.

In his public speeches, Rosengren, who has headed the Boston Fed since 2007, has emphasized the vulnerability of nonbank financial institutions and the central role they played in the financial crisis. He has also focused on the need to reform money-market mutual funds, reforms the SEC adopted last month after years of delays. Rosengren said Wednesday that those reforms were an improvement but that he would have liked them to do more to protect against runs on the funds.

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